Of Taxes, Penalties, and Liberty

The US Supreme Court's decision on the constitutionality of the Obama Administration's health-care plan has set off a new firestorm of controversy instead of ending it, notes Peter Schiff of Euro Pacific Capital.

In the wake of my last commentary on the horrendous Supreme Court decision upholding Obama's health-care plan, several people have pointed out that I erred in saying that the income tax is a "direct tax."

While it is technically correct that the Court ultimately declared it to be an excise and not a direct tax, it is important to understand how it arrived at that opinion, and why the decision has no practical relevance to the way the tax has been enforced. Just as it appears to have done with Obamacare, the Court came up with a technically constitutional pathway to allow the government to collect a tax in a blatantly unconstitutional manner.

In the 1895 Pollock v. Farmers' Loan and Trust case, the Supreme Court declared the original Income Tax of 1894 unconstitutional because it imposed a direct tax on individuals that was not apportioned to the states according to the taxing provisions of the Constitution. For example, it said that a tax on rental income is the same as a direct tax on the property that produced the income. In other words, a tax on income was tantamount to a tax on its source.

To get around this, in 1913 Congress passed, and the state governments ratified, the 16th Amendment, which authorized a tax on income from whatever source derived without regard to apportionment. However, in 1916, the Supreme Court ruled in Brushaber v. Union Pacific Rail Road that the Amendment "conferred no new taxing power to the Federal government," and that it "contained nothing challenging or repudiated its ruling in the Pollock case."

Instead, the Court said that in order to be constitutionally taxed as an excise, income must first be separated from its source. A few years later in Eisner v. Macomber (1918) and Merchants Loan and Trust v. Smietanka (1921) the Court provided a practical guide to doing just that: defining income, for purposes of the 16th Amendment, as a corporate profit.

When determining profits, a corporation subtracts expenses from its sources of income, such as sales and rents. The difference, called profit, could then be subject to an income tax. But if a corporation has rental income, but derives no profit after backing out all of its expenses, then the rents—and therefore the property—are not taxed.

Were it not for this separation, a tax on personal income from rents, dividends, wages, etc. would be a direct tax, as described by Pollock, Brushaber, Eisner, and Smietanka.

The problem is that the modern income tax is not merely being levied as an excise tax on corporate profits, but as an unapportioned direct tax on the personal income of every American. This is precisely what the Supreme Court has repeatedly held to be unconstitutional. Yet lower courts have serially ignored the reasoning behind these Supreme Court decisions, and have allowed the Federal Government to impose a tax in the precise manner that the Supreme Court ruled it lacked the constitutional authority to do.

The Founding Fathers made it difficult for Congress to levy direct taxes because they considered the more easily avoidable excise taxes to be self-correcting as to abuse. They also wanted to make it more difficult for poorer states to vote for taxes that would be paid disproportionately by wealthier states. As a result, they believed that during peacetime, the Federal Government would rely primarily on excise taxes, and would resort to direct taxes mainly during wartime.

To levy an apportioned direct tax on personal income, Congress would first have to decide how much it wanted to raise, then assign each state its pro-rata share. So a $1 trillion dollar income tax would require Mississippi and Connecticut (each with about 1% of the US population) to pay about $10 billion.

However, since per capita income in Connecticut is 80% higher than it is in Mississippi, federal income tax rates in Mississippi would have to be 80% higher than the rates in Connecticut. This makes it less likely that Mississippi's congressional delegation would support such a tax.

With the way the income tax is currently enforced, Mississippi happily votes for levies that fall predominately on residents of wealthier states. This is precisely what the Constitution was written to prevent.

Just as a tax on land based solely on its rental income is the same as a direct tax on the land itself, a tax on individuals based solely on their decision not to buy health insurance is a direct tax on individuals. To get around this, Chief Justice Roberts ruled that the new health-care tax is indirect because not everyone will have to pay it.

However, the percentage of people ultimately subject to a tax does not determine into which category the tax falls. Less than 2% of Americans were subject to the original income tax, yet the court still viewed it as a direct tax.

The bottom line is that the Supreme Court has a history of giving the government latitude to get around the Constitution. Instead of looking at the intent of legislation (even when the legislators were alive to be asked), or even its practical effect, the Court looks for any legal technicality upon which to base a ruling of constitutionality.

That is what happened with the income tax, and is now occurring with the Affordable Care Act. Had the Supreme Court been more forthright with the income tax, the country would not now be suffering from a destructive and pervasive tax that was originally intended to be a small levy targeted only at the top 1% of American earners.

Remember, the Court's sole rationale for ruling the exactions in the Affordable Care Act were taxes rather than penalties was its belief that the taxes were too low to actually compel anyone to buy health insurance. This made it consistent with the Court's view that Congress lacks the legislative authority, under the commerce clause, to compel Americans to buy health insurance. If the court believed that the tax was actually high enough to leave Americans with no rational choice other than to buy health insurance, Roberts would have ruled the tax unconstitutional.

His observation that the tax is too low to be effective may be the one thing the Court actually got right. However, once the government realizes that it underpriced the fines, it will have no choice but to raise the tax rate substantially to stop healthy people from rationally dropping their coverage (because insurance companies could not deny them similarly priced coverage after they got sick).

Just as they routinely do now with respect to income taxes, the lower courts will likely misinterpret the Supreme Court's ruling and rubber stamp any future rate hikes. For political reasons, it is unlikely that a Constitutional challenge to such an increase will ever make it back up to the Supreme Court.

This leaves us few good options. Unless Congress repeals the legislation quickly, we will likely have to live with it for a long, long time. Sadly, despite the Romney and the Republicans' promises to do just that with election victories this fall, there is virtually no precedent for government giving up a power that it has fought to take.

In the end, Americans will be forced to purchase health insurance in the manner the Supreme Court just ruled to be unconstitutional.